The strategy that has the best chance of allowing the Republic of Marshall Islands (RMI) to achieve fiscal sustainability after FY2023 involves substantial fiscal consolidation. The alternative (policy action) scenario involves a substantial fiscal adjustment starting in FY2009. Projections show that this strategy can succeed in achieving budgetary self-sufficiency. Fiscal consolidation will be difficult, and will have to be accompanied by structural reforms to improve real growth. Substantial fiscal consolidation in the short term is necessary to achieve budgetary self-sufficiency after 2023.

1. The Republic of the Marshall Islands (RMI) needs to tackle fiscal consolidation given the steady decline in Compact grants and increasing external debt service payments. Compact grants will decline by $0.5 million per year (expiring in 2023) and debt services on external debts will increase steadily, peaking in 2019. RMI’s heavy reliance on the public sector makes cutting expenditure difficult, leaving the improvement of revenue collections a critical step toward the required fiscal consolidation. A comprehensive tax reform is vital to raise additional revenue, which will help achieve the necessary fiscal adjustment.

2. The authorities have recently shown renewed interest in tax reform. Prior to this impetus, tax reform lingered despite a detailed action plan developed by the Pacific Financial Technical Assistance Center (PFTAC). Lately the authorities have strengthened the tax audit unit and are aggressively pursuing non-compliant entities. In addition, the authorities are working together with key stakeholders in the process. Nevertheless, the tax reform is in the initial stage that requires ongoing efforts to obtain its intended results.

3. This chapter reviews the current tax regime, and outlines steps toward a comprehensive tax reform. Section A describes RMI’s current tax structure, and compares it to other Pacific island countries (PICs). Section B examines some weaknesses in the current tax regime, section C highlights actions that the government has recently undertaken. Section D proposes changes to address the shortcomings in tax regime. It argues that comprehensive tax reform should address the weaknesses in both tax administration and tax policy. Section E concludes that RMI should implement tax reform as soon as possible, focusing initially on tax administration matters.

A. Tax Revenue in RMI

4. RMI’s revenue composition is similar to other PICs that receive large external grants. In most PICs domestic revenues usually come mainly from import duties and sales taxes, while corporate taxes contribute a much smaller share of tax revenue. RMI receives external grants amounting to 40 percent of GDP, the second highest among the PICs (after Kiribati).

Fiscal Position In PICs

Source: Fund staff estmates

5. The tax revenue in RMI comes from three major sources (Box II.1).2 The largest tax component is from wages and salaries, which is over $11 million and contributes about 40 percent of tax revenue. The second largest component is import duties at about $8 million, contributing about one-third of total tax revenue. Gross revenue tax (GRT), at $5 million in FY2007, accounts for about 17 percent of total tax revenue. Domestic revenue in RMI has been stable at an average of 17 percent of GDP since FY2000, but has increased in nominal terms to $27 million in FY 2007.

Fiscal Position in RMI

Source: RMI government.

Sources of Domestic Tax Revenue

Source: RMI government.

B. Weaknesses in the Current Tax Regime

6. The tax policy on the three main taxes contains weaknesses, which hamper revenue collections. These include:

Tax on wages and salaries. The tax on wages and salaries raises the concerns of equity and efficiency. Deductibles on income tax are applicable to the low-income class and is eliminated once income exceeds a certain threshold (at $5,260 per year), leading to a sharp increase in the marginal tax rate on additional wages and salaries.

Import duties. Tax rates on imported goods are not uniform, and sometimes levied on a per-unit instead of a value basis. As a result, similar type of imported goods may carry different duties without an objective customs valuation.

Gross revenue tax (GRT). GRT is levied on a revenue basis, instead of a net profit basis that is widely used in other countries. Although the current GRT schedule is uniform across businesses, the effective tax rates on net profit vary significantly depending on their operating scales. It does not take into account the production and operation costs in the businesses, and tends to favor those that operate at a low turnover, but high profit margin. The GRT also discourages the replacement or reinvestment in capital equipment and human capital for the long-term benefits.

Box II.1.Marshall Islands: Tax Regime

The three main sources of tax revenue are wages and salaries tax, import duties, and GRT. Together they account for more than 90 percent of annual tax revenue. Other types of taxes include property tax, hotel and resort tax, and non-resident gross income tax. Some local governments also impose a general sales tax in addition to the taxes of the national government. The tax rates on different categories are listed below.1

8 percent on most imported goods, with a lower rate of 5 percent on foodstuff. A selected number of goods (cars, tobacco products, and alcoholic and carbonated beverages etc) are subject to an excise tax levied at ad-valorem or specific rates that range from 2 percent to 150 percent.

Fuel tax

Tax on gasoline is at 25 cents per gallon; diesel at 8 cents per gallon.

Immovable property tax

3 percent on gross income or rent from property leased.

Hotel and resort tax

8 percent on daily room rate on hotel and resort facilities.

Non-resident gross income tax

10 percent on the gross income earned by non-resident.

Local government sales tax

General sales tax on goods at 4 percent in Majuro local government; sales tax of 10 percent at the wholesale level in Kwajalein Atoll local government.3

1 Ministry of Finance (2008) and Andic (2005).2 On a per annum basis.3 Both local governments also impose a tax on gasoline, alcoholic beverages, and hotel rooms that vary with the sales tax listed above.

7. There are further weaknesses in the tax regime, which include:

Cascading tax effect. The tax rates are cascading towards the final consumers, as the duties on imported goods cannot be deducted from the GRT or the sales tax imposed by the local governments. A large portion of tax burden is likely to transfer to the final consumers under the small market structure in RMI.

Membership in regional trade arrangements.3 RMI’s commitment to regional trade arrangements poses an additional challenge by introducing more complex tariff structures as different rates could apply to the same goods depending on the origin of the goods (within or outside the region). When all agreements come into effect, the associated customs revenue could eventually decline.4

8. The present tax administration also has limited enforcement capacity. This leads to a low compliance across all type of taxes, hampering the authorities’ ability to generate sufficient revenue at the present tax rates. Some weaknesses in tax administration are as follows:

Low tax compliance. The non-compliance rate is estimated to be 25–50 percent. Based on this rate, it is calculated that improving compliance could generate about $7-8 million in additional tax revenue (Box II.2).

Weak administration in customs. There is no objective valuation of imports and the procedure in levying duties is inefficient. Mis-reporting and undervaluation tend to be common (McNeill (2007) and PITAA (2006)).

Lack of coordination between revenue collection agencies. RMI currently has three revenue collection agencies: national government, local governments, and social security administration. They run parallel collection and auditing units with duplicating efforts. Reported inconsistencies are not uncommon across agencies.

Arrears from the local governments. Some local governments have built up tax arrears to the national government.

Non-compliance is estimated to be about 25–50 percent, and remains one of the key issues in RMI’s tax reform.1 Previous studies suggest that the informal sector (mostly consisting of low-income individuals and mom-and-pop businesses) is more likely not to comply.2 The example below illustrates the additional tax revenue that could have been collected under different scenarios. Several assumptions for the calculations are taken:

Calculations are shown for non-compliance rates at 25, 35 and 50 percent respectively. The range of 25–50 percent is estimated by PFTAC experts.

The taxable income of the non-compliers as compared to tax compliers is assumed to be 30–70 percent smaller. This assumption takes into consideration that the operating scale or personal income for non-compliers is generally smaller than those that file tax.

The issue of under-reporting for the compliers is abstracted in the calculations.

Given data limitations, a benchmark estimate was calculated to quantify the problem of non-compliance. The figure below shows the additional tax revenue that could have been collected under full compliance based on the estimated tax revenue in 2007. The range varies significantly given the non-compliance rate and the difference in taxable income between compliers and non-compliers. However, a reasonable estimate would be about $7 to 8 million per year, assuming a 35 percent non-compliance rate, with the non-compliers’ income 30–40 percent smaller than that of compliers. The results suggest that the tax revenue loss arising from compliance is large, and measures to enhance compliance are critical in the tax reform.

Tax Revenue Arising From Non-compliance

Source: Fund Staff estimates

1 Estimates are from PFTAC and are consistent with Ministry of Finance (MoF) estimates. The non-compliance rates are similar across different type of taxes. Other issues related to under-reporting, and tax accruals and arrears further complicate the progress in the tax reform.2Robles (2007) suggested the informal sector is about 30–40 percent smaller than the formal sector.

C. Reform Efforts

9. Tax reform efforts lingered for many years. In 2003, PFTAC designed a modernization strategy and action plan for customs, including improvements to the Customs Act, automation, and compliance units. The FY2006 Budget Statement also outlined many changes to tax regime, including unifying import duties and changing the income tax structure. There was, however, limited follow-up action on these initiatives.

10. Since the publication of the FY2006 Budget Statement, tax reform action has taken the form of:

Changes in tax policy. Fuel tax on gasoline and diesel was adjusted to 25 cents and 8 cents per gallon respectively.

Improvements in tax administration. A number of measures to strengthen the tax collection were initiated and a dialogue with key stakeholders has been established (Ministry of Finance (2006 and 2007)).

11. Recently, however, the authorities have shown renewed interest in tax regime reforms. They have sought guidance from PFTAC on the tax policy front, and have taken several steps on the tax administration front. In particular, the authorities have enhanced coordination among the revenue collection agencies in tax filing matters. They also attempted to strengthen the tax audit unit, and pursued more aggressively the non-compliant businesses.5 They have begun the issuing of public notices in attempt to strengthen tax enforcement, and plan to conduct an island-wide survey in increasing the public awareness of the tax reform.6 Nevertheless, the tax reform is in the beginning stage that requires on going efforts to achieve its intended results.

D. The Way Forward

12. A comprehensive tax reform should address the weaknesses in both tax policy and tax administration. At least initially, the authorities should consider implementing many of the proposed changes spelled out in the 2006 Budget Speech. Further measures that are consistent with those outlined by PFTAC should be adopted, as they are necessary to achieve fiscal consolidation.7

13. In designing and introducing the new tax regime, the authorities should adhere to several key principles. These principles are generally applicable regardless of specific tax policy or administration structure.

Simplicity and Fairness. The new tax regime should contain simple features that provide a level playing field among individuals and businesses. Tax exemptions or non-compliance should be kept to a minimum.

Low compliance cost. The tax reform should attempt to reduce the compliance cost for individuals and business. The cost of complying with the new tax rules need to be low enough to avoid non-filings from the taxpayers.

Broad tax base. Given the non-compliance issue, the current tax regime has a concentrated tax base with relatively high tax rates to generate sufficient tax revenue. The tax reform may broaden the tax base with improved compliance rate.

Minimal distortions. The new tax regime should only contain minimal distortions on trade and investment opportunities.

14. The authorities should revise the tax policy in accordance to the key design principles:

Gross revenue tax. The authorities should adopt a corporate tax on the basis of net profit, as the existing GRT tends to violate the above principles of fairness and minimal distortions. The corporate net profit tax would take into account the production cost and other relevant expenses.

Import duties. A uniform structure based on the value would be preferable once the customs develop an objective valuation procedure and method.

Tax on wages and salaries. Deductibles on personal income should be applicable to every employee to achieve fairness and avoid a sharp rise in marginal tax rate.

15. The authorities should take additional steps in enhancing tax administration, including:

Improving tax compliance from individuals and businesses. Given a low tax compliance rate, the authorities should further strengthen the audit units and increase the penalty for repeated non-compliant cases.8 Aligning foreign business to RMI’s tax laws would be important to avoid unfair treatments among domestic and foreign businesses. The customs collection of import duties should be improved by shortening the clearance procedures, using a consistent valuation method, and introducing reliable technology. The authorities may learn from the successful experience of the Social Security Administration in addressing non-compliance issues.

Harmonizing tax collection of national and local governments. It is necessary to eliminate the dual and duplicate efforts running parallel across various revenue collection agencies. Harmonization in tax collection also improves the credibility to address the non-compliance. Information sharing and coordination beyond the measures undertaken would be necessary.

16. In the long run, a consumption-based tax regime could benefit the economy and might secure revenue sources, but there are downside risks. Several PICs have introduced the value-added tax (VAT) regime as part of a comprehensive tax reform.9 The efficiency of the VAT is generally high across the PICs (Grandcolas (2004, 2005)). However, there would be downside risks if the tax reform was not accompanied with a strong political commitment, a simple regime with minimum exemptions, and a detailed preparation on the implementation plan.

E. Conclusions

17. RMI should implement tax reforms as soon as possible to help it face the challenges ahead. In light of declining external grants and current weaknesses in the tax regime, the authorities need to continue their determined efforts in tax reform. Tax reform is a crucial element in the required fiscal consolidation to achieve budgetary self-sufficiency. It is important that the new tax regime is designed to be simple and fair, easy to implement, with relatively low compliance costs, and with minimal distortions on investments.

18. Several issues should be noted in designing and introducing a new regime. The authorities need to address the high non-compliance and harmonize tax collection across government agencies. They have taken initial measures to involve the key stakeholders during the process of the tax reform. It is important to extend their determined efforts on the remaining weaknesses of the current tax regime. Effective tax policy, coupled with strong enforcement, would improve the revenue collections towards the required fiscal consolidation.

References

Andic, Fuat,2005, “Tax Policy and Administration in the Republic of the Marshall Islands,”Asian Development Bank.

Andic, Fuat,2005, “Tax Policy and Administration in the Republic of the Marshall Islands,”Asian Development Bank.)| false

1/The CPI index developed in 1977 was revised. The revised CPI index, starting in 2003Q1, consists of prices of 61 goods and services collected in Majuro organized into nine groups. The CPI index is rebased to 2003Q1=100 from 1982=100.

Source: Data provided by the RMI authorities.

1/The CPI index developed in 1977 was revised. The revised CPI index, starting in 2003Q1, consists of prices of 61 goods and services collected in Majuro organized into nine groups. The CPI index is rebased to 2003Q1=100 from 1982=100.

2/Compact funding pertaining to the Kwajalein Atoll Trust Fund and Kwajalein resident and landowner compensation Trust Fund contributions by the U.S. and Taiwan Province of China, are regarded as capital transfers.

3/Official transfers include current transfers but excludes capital transfers and Trust Fund contributions.

4/Includes changes in social security fund investments, banking system assets held overseas, and government assets held in the capital and special fund accounts.

5/Changes in government assets, excluding the general fund.

6/Including MIITF which is deposited in domestic financial institutions.

2/Compact funding pertaining to the Kwajalein Atoll Trust Fund and Kwajalein resident and landowner compensation Trust Fund contributions by the U.S. and Taiwan Province of China, are regarded as capital transfers.

3/Official transfers include current transfers but excludes capital transfers and Trust Fund contributions.

4/Includes changes in social security fund investments, banking system assets held overseas, and government assets held in the capital and special fund accounts.

5/Changes in government assets, excluding the general fund.

6/Including MIITF which is deposited in domestic financial institutions.

In addition to the three major taxes, RMI also has immovable property tax, hotel and resort tax, non-resident gross income tax, and local governments’ sales tax (Box II.1). These accounted for less than $1.5 million on average in past years. Non-tax revenue includes fishing rights fees and ship registry fees.

RMI participates or is negotiating a number of free trade agreements with other PICs, Australia, New Zealand, and the European Union. RMI is involved in the Pacific Agreement on Closer Economic Relations and the Pacific Islands Countries Trade Agreement. It is discussing with the European Union on a new trade arrangement under the Economic Partnership Agreement.

For example, Fiji, Samoa, Cook Islands, and Papua New Guinea introduced the VAT in the 1990s, and Tonga introduced it as recent as in 2005. The VAT across the PICs tends to be single-rate and within a 10-15 percent range, with the VAT generating about 20-50 percent of the total tax revenue.